European economies catching up to the rest of the euro area suffer from higher inflation. The conventional structural explanation – the Balassa-Samuelson effect – doesn’t match the data, causing some to argue that cyclical effects must be driving economic differences. But the authors of CEPR Policy Insight 20 argue that structural changes – important improvements in product quality – may explain the phenomenon.

There are persistent differences in economic performance within the euro area, particularly with respect to inflation. Catching-up economies suffer higher inflation rates. Fast growing economies like Spain and Ireland have exhibited above-average inflation rates over the last decade, and Slovenia has been also struggling with high inflation rates since adopting the euro in 2007. According to conventional economic convergence theory, this is due to the so-called Balassa-Samuelson effect, in which productivity gains in the tradable sector pull up wages in the lagging non-tradable sector, inducing price increases in the latter sectors and thus overall inflation. This results in a real exchange rate appreciation.

However, empirical work has lent little support to this theory. For example, for the Visegrad-4 countries – the Czech Republic, Hungary, Poland, and Slovakia – the relevant literature over the past five years failed to quantify a sizable Balassa-Samuelson effect, with the average effect from 20 recent studies accounting at best for one-third of the actual real exchange rate appreciation of more than 30% from 1995 to 2006.

Against the background of the small empirical Balassa-Samuelson effect, commonly associated with structural convergence, the recent strong real exchange rate appreciation might be interpreted as a cyclical development that poses policy challenges – especially in relation to the euro area entry. The ‘Traffic Light Analysis’ recently heralded by Danske Bank (2007) attributes recent economic developments in the majority of the new EU member states of central and eastern Europe to the first phase of a boom-bust cycle. This explantion also seems implicit in comments by some ECB executive board members emphasising the challenge of cyclical overheating for the region (Bini Smaghi, 2007).

Is Balassa-Samuelson relevant?

The absence of evidence for the Balassa-Samuelson effect as an explanation for differences in economic performance in Europe may be due to the absence of structural conditions assumed in the theory, rather than the dominance of cyclical effects. The theory assumes that (1) productivity growth in tradable sectors drives their real wages, (2) wage growth in tradable sectors lifts wages in other sectors, and (3) productivity growth in non-tradables is zero so that wage increases fully translate into higher prices. There is evidence that all three assumptions are violated in the Visegrad-4 economies. First, there may be a disconnection between productivity growth and real wages in the manufacturing sector, as would be the case if large subsectoral dispersion is behind strong productivity growth in the tradable sector. Indeed, high-tech industries recorded enormous gains (around 30% per annum) while low-tech industries exhibited very little productivity gains. Very large productivity gains are unlikely to be proportionately reflected in real wages and therefore real wage increases will be lower than the productivity growth at the industry level. Evidence indicates that, in manufacturing, high productivity growth goes hand-in-hand with an increased standard deviation in productivity growth.

Second, if wage equalisation is not complete between the sectors, i.e. if wages turn out to increase faster in the tradable sector than in the nontradable sector, there is an incomplete pass-through from the tradable sector’s wages to those of the non-tradable sector. Moreover, if wages rise more rapidly in the nontradable sector, then wages in that sector are not set by wage developments in the tradable sector. According to available data, the assumption of proportionate wage equalisation holds only for Hungary and Slovakia.

Third, productivity gains in the nontradable sector were surprisingly strong in Visegrad-4 countries and offset the effect of productivity gains of the tradable sector on the relative price of non-tradables. Nontradable sector productivity rose by more than 4% annually in the Czech Republic and Poland. Even if there was a proportionate relationship between the productivity differential and the relative price of nontradables, the final impact on the inflation rate depends on the share of nontradables in the CPI. However, the share of market services is rather small – about 20%.

Finally, it seems that purchasing power parity does not hold in the Visegrad-4 countries, since the extent of the real effective exchange rate appreciation is practically the same for both the producer price index and the consumption price index. This implies that the real effective exchange rate appreciation is driven by the tradable goods sector. Therefore, it is unsurprising that empirical estimates of the Balassa-Samuelson effect are relatively small and by far insufficient for the explanation of the observed annual real effective exchange rate appreciation.

Structural differences

In a new CEPR Policy Insight (Égert and Podpiera 2008), we argue that the trend of real effective exchange rate appreciation in the Visgrad-4 economies is most likely due to structural changes in the production of tradable goods and not the Balassa-Samuelson effect. Namely, a shift towards higher quality (value) products has increased reported price indices and caused a real effective exchange rate appreciation because there is incomplete quality adjustment in price indices by national statistical offices.

This shift has occurred on both the demand and supply sides. As they have become richer, consumers in the catching-up economies have upgraded the quality of their consumption baskets. Clearly, quality effects should not show up in inflation rates. In practice, however, filtering out quality effects is difficult even for developed countries, let alone the cases where those changes happen more rapidly.

On the supply side, the unit value ratio (a ratio of export unit value of Visegrad-4 countries over the unit value of export of the rest of the world) increased substantially: 60% from 1995 to 2004. Fabrizio et al. (2007) argue that this increase in unit value of export is the unique source of the Visegrad-4 countries’ gains in international market shares since 1994. This is to be attributed to quality increase as the alternative explanation of pricing to market effects is much smaller; Cincibuch and Podpiera (2006) found that pricing-to-market can justify a prolonged disparity between export and producer prices up to 10%.

The positive correlation between the degree of economic development and the measured price level is another indirect clue that the measured price indices are to some extent driven by improvements in quality of products. It thus would support the proposed explanation of quality-driven real effective exchange rate appreciation of the Visegrad-4 countries.
Therefore, we suggest that the recent significant real exchange rate appreciation in Visegrad-4 countries is likely not a sign of cyclical overheating but a structural phenomenon – one not predicted by conventional economic convergence theory.